Bbby Case Essay

Vita Kormych
Olivia Taddei
Kimberly Aardsma
FINC 357
Bed Bath & Beyond Group Case

The business risk of BBBY can be categorized as medium to low. On the low side that is due to the fact that BBBY is a common goods company and the risk of default in the common goods industry is relatively low. But BBBY also has a lot of competitors with a higher market share and some of them even offer a higher ROE, like Best Buy (23.4%) and William Sonoma’s just a little above BBBY’s (19.5%), compared to BBBY ROE of 20.1%. The main competitors are chains of superstores such as Target and Best Buy. While BBBY has no debt on its balance sheets due to the conservatism of its management team, it invested a lot of its money in short-term securities and lately these investments weren’t profitable enough due to the low interest earned. Therefore, it is clear that the company needs a new strategy as to the future of their excess funds.
As mentioned above, we believe that the company does have a lot of excess cash that needs to be organized in a better way to provide its owners with a higher return. The company could pay out the excess cash as one time dividend or it could implement stock repurchasing. As for the first alternative, it is highly inefficient because if the company offers higher ROE than the current market does, it should keep the money in the company. Companies always do what is best for their shareholders.
Therefore, it leaves us with only one option – to repurchase some of the shares back from the public to increase the price of the stock that will remain outstanding. The analyst’s suggested ways to do so include 40% and 80% debt ratios.
As the company faces low business environment risk, it could afford to borrow more money. Therefore, we proceeded with the analysis of the extreme of 80% debt ratio first.
The value of leverage VL can be found as following:

VL =VE +VD, where VL –is a value of leverage; VE –is the value of equity; VD – a value of debt. Also, VL can be found: VL =VU + PV tax shield – The Costs of Financial Distress, where VU–is the value of equity without debt. From the Exhibit 1, we can see that by taking on 80% of debt the company will be able to save up to $23,816,000 per year ($250,075 - $226,259). Assuming the infinity (?) of business, the present value of such tax savings can generate a company up to $30.246 billion in cash in the future that can be safely invested in Treasury Bonds or other high liquidity securities: PV tax shield = CF/I = (Debt x Interest x Tax Savings)/I = Debt x Tax Savings; PV tax shield = $1.27billion x 23,816,000 = $30,246,320,000 The value of equity without leverage: VU= # shares x Price per share = $37.00 x 296,854 = $10,983,598,000

The value of leverage will be: VL = $30,246,320,000 + $10,983,598,000 = $41,229,918,000. Therefore the value of the equity with 80% leverage will be: VE =$41,229,918,000 – $1,270,000,000 = $39,959918,000.

With 45,135 shares repurchased (including 1.27billion of borrowed funds and 400mln of excess company’s cash) the new market price per share should equal approximately $158.75:

Price per Share = $39,959918,000 / 251,719 ≈ $158.75.

That is almost 330% increase from current $37.00 per share price. And that is definitely something the company might want to consider.

But Exhibit 2 shows us that this increase in potential value wouldn’t come to BBBY without costs. The Actual 2003 data table shows that according to the key financial ratios, the company can be considered to be in the AA to AAA industrial categories, most likely AA company, as it doesn’t have any debt on its balance sheet. But with 80% debt ratio, company will most likely be moved far back to the BBB or even BB category. But by keeping only 40% debt ratio, company’s financial distortion will allow it to stay in A-AA category while still increasing its Market price per share (somewhere in between $37.00 and $158.75

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